Private cost

The private cost is any cost that a person or firm pays in order to buy or produce goods and services. This includes the cost of labour, material, machinery and anything else that the person of firm pays for. The private cost does not take into account any negative effects or harm caused as a result of the production.

A firm that operates a coal-fired power plant only considers the cost of what goes into producing electricity such as the cost of coal, labour to operate the plant etc. The plant produces harmful emissions such as CO₂ and particulate matter among others. These emissions have a negative effect of society, pollution increases the incidents of respiratory illness which increases the burden on the healthcare system. The cost is paid by the government (or healthcare system).

Because the firm does not pay the cost for the harm they create an inefficiency in the market, this inefficiency is called a negative externality. This can be corrected if the firm is made to pay the private cost of production and the cost imposed on society from the emissions called the external cost. If the firm pays both costs the it is paying the social cost meaning that it has accounted for the harmful effects that were previously not considered.

The social cost is the private and the external cost together.

The cost of production would rise to the socially efficient level (no externality) if the firm took additional measures to lower or eliminate the amount of emissions from generation. The firm would have to invest in new air pollution control devices in order to lower emissions. The new investment makes the generation of electricity more expensive and therefore the price the firm sells their electricity for would have to rise.